Factor Sensitivities to Alternative Macroeconomic Environments

University essay from Handelshögskolan i Stockholm/Institutionen för finansiell ekonomi

Abstract: In this thesis, we examine how different factors are exposed to alternative macroeconomic environments. We apply a range of different approaches in order to explore these relationships. Firstly, we analyse mean excess returns and Sharpe ratios of factors in different macroeconomic regimes. We define the regimes by taking the median of macroeconomic indicators, and, alternatively, by applying a Markov switching model to the indicators. Secondly, we apply a two-state Markov switching model to excess returns, including macroeconomic indicators as explanatory variables. We cover all major factors in our research - size, value, momentum, quality and high dividend yield - as well as the main risk-efficient factor strategies, such as minimum volatility and risk weighted. We find that momentum, mid cap and large cap are pro-cyclical factors, which benefit significantly from favourable macroeconomic environments, while small cap, quality, high dividend yield, minimum volatility and risk weighted are relatively more resilient to negative macroeconomic developments. Finally, we construct a dynamic, rule-based factor allocation strategy and show that it significantly outperforms market and equally weighted factor portfolios over different investment horizons.

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